Making Money Out of Commercial Property $$$

The objective of a commercial renovation or improvement is similar to residential property, i.e. the property should be brought up to an appropriate standard so it appeals to prospective commercial tenants and/or prospective purchasers and one should not over capitalize the property.

The requirements of commercial tenants will vary depending on how they will be using the property i.e. whether it is for an office, retail or industrial purpose. As with residential property the requirements and tastes of commercial tenants and buyers will vary, so you should stay neutral with the improvements, otherwise a tenant or buyer may walk in and want to completely change what you have done. The improvements should be from practical perspective and increase the potential of attracting more rent.

Market research will tell you what improvements will draw tenants and what the ceiling rents are for similar properties in the area. You do not want to spend money on things that will not contribute to being able to increase the rent. (We often ask local valuers in an area what the rental ranges are for various types of properties).

Some typical things that could increase the rent and improve the value of the property are;

• ‘Clean it’
• Mezzanine level (add more floor area & rent it out at a rate per sqm)
• Add an office
• Add internet and telephone connections
• Awning
• New floor covering
• A/C system
• Suspended ceiling
• Grease trap
• New plasterboard walls + paint
• Fit-out per tenants requirements
• Remove walls or add walls (partition walls are easy to add and remove)
• Create new entry and exit ways

Sometimes it is best to just tidy up the property and repair / replace the basics and offer the new tenant a fit-out in lieu of increasing their rent. (Or your existing tenants may ask you to spend money on the property in lieu of a rental increase).

For example

Say you offer to pay $50k in fit-out costs for an incoming tenant or existing one, and the tenant agrees to pay an increased rent of $25sqm x 250sqm (of floor space) = $6250 per year. At a capitalisation rate of 8% the increase in value would be $6250 ÷ 8% = $78,125. We would consult with a local valuer before spending a cent to gauge what the potential lift in value would be. (I.e. maybe the cap rate in that area is 7%, which would improve the value by more than $28k).

You may want to achieve an increase of more than $28k in value to make the exercise worthwhile however; this is an example. Of course you might also be able to depreciate the $50k in improvements which then starts to really improve your cash flow.

So even if your loan repayments were 10% x $50k = $5k per year you would be +ve cash flow on your expenditure + have further depreciation deductions.

Obviously if an existing tenant approaches you mid way through the lease requesting such improvements you would have to do an amendment to the current lease.

We recently negotiated with an industrial tenant to build them a further 500sqm of warehouse space at a costs of approx $500k.

This attracted a further rent of 500sqm x $110 per sqm = $55k. So will increase the value by $687,500 (55k ÷ 8%). So even after interest repayments we have increased the +ve cash flow and also increased equity.

Hope this helps.

“Say you offer to pay $50k in fit-out costs for an incoming tenant or existing one, and the tenant agrees to pay an increased rent of $25sqm x 250sqm (of floor space) = $6250 per year. At a capitalisation rate of 8% the increase in value would be $6250 ÷ 8% = $78,125”.

Hi Gary,

The $28k is the difference between what you spent on the fit out ($50k) and the uplift in value ($78k).

So the return on investment (ROI) is $28k ÷ $50k = 56%. Not a bad return for about a months work. Obviously, this increase is ‘equity’ as opposed to cash.

To understand how you increase the value of commercial property you need to understand the capitalization method of valuation or income method.

I can explain this in further detail if you want me to?

They are good additional points that you raise.

If you were going to spend money on a fit-out you would certainly want to be confident that your tenant was going to be there for the long term and/or you retained the ownership of the fit-out, depreciated it and could even leave the works in place for the next tenant to use. As such the nature of the improvements would have to be appropriate.

A fit-out (term used in the broad sense) could include a/c, floor coverings, paint etc, so the ownership could be retained by you and be depreciated.

Appropriate research would need to be done to ensure that the capital expense was not wasted and certainly you would not want to ‘kick the can for $50k’ and have your tenant leave in five years and not be able to re-use the fit-out.

We always consult with local valuers to get a ‘projected valuation’ before undertaking any such exercise. You don’t have to guess with commercial property, you can negotiate any works ‘subject to’ adequate terms and rent and also ensure that your uplift in value will allow you reuse equity and/or sell your asset for a profit.

My 2nd example of $200k profit would work better for this.

Commercial property is certainly not for the inexperience and I would suggest a lot of research before investing in it for the first time.

Our due diligence checklist has over 40 check points on it; many years of buying commercial property teaches you a few things.